US economy: The debt deal’s biggest loser

By choosing fiscal repair instead of economic repair the savings in the deal would be wiped out if the US economy fails to muster strong growth.

FP Editors August 02, 2011 10:09:44 IST

Guess who’s the biggest loser of the US debt deal? The US economy.

Indeed, if you thought that the entire drama on Capitol Hill was over ensuring the future health of the economy, you'd have been wrong.

The deal does very little in that regard.

"The result is a mishmash of expedient stop gaps and promises that tilts heavily to Republican priorities while guaranteeing more wrangling and uncertainty in the months ahead. It does nothing to support the near-term economic outlook, and makes less progress on long-term fiscal consolidation than hoped,” the Economist noted.

Yes, fiscal consolidation.  That was the lofty long-term goal. But what about more immediate goals like economic recovery? With economic growth at a glum 1.3 percent in the three months to June, and unemployment stubbornly above 9 percent, several economists have been arguing for more spending, not less, to prevent the sputtering economy from flatlining.

US economy The debt deals biggest loser

US House Speaker John Boehner holds a news conference with Representative Paul Ryan (R-WI) (L), Representative Jeb Hensarling (R-TX) (2nd L), Majority Leader Eric Cantor (R-VA) (3rd L) and Representative Cathy McMorris Rodgers (R-WA) (R), about debt relief legislation at the U.S. Capitol in Washington, August 1, 2011. Reuters

But the debt deal emphasises spending cuts, although most of the cuts will be identified by lawmakers in future years in order to avoid dragging down the weak economy right now.

Still, several commentators have been left unhappy with the deal —and the messy way in which it was done.

According to a commentary in Time Magazine’s Curious Capitalist blog:

“We can all forget about US fiscal policy being employed to stimulate the anaemic recovery in the world's largest economy. The debt deal, by capping annual appropriations and imposing $2.4 trillion in spending cuts over the next decade, takes any hope of further stimulus off the table.”

True, while some analysts have pointed out that the cuts, while huge in nominal terms, are modest when spread over 10 years and compared to the size of the US economy, Barclays Capital warned that much of the savings in the deal would be wiped out if the US economy fails to muster strong growth.

Yet politicians don’t seem to care about that. As the Curious Capitalist notes, “Washington has chosen fiscal repair over economic repair”.

That has implications not just for Americans, but also for the rest of the world.

The American economy has always been considered the engine of growth for the world economy, so a slowdown there inevitably affects the rest of the world. Even roaring China will find it difficult to continue at the same pace because a large share of its exports is destined to the US market.

The drawn-out wrangling among American politicians, and their inability to take into account how their actions heightened the risks to the global economy will also not go unnoticed.

Countries like China, for example, now have even more incentive to diversify away from holding US assets. China's central bank holds an estimated $1.16 trillion in US Treasuries. Japan, the second-largest foreign owner, holds $912 billion. They will not be happy at the way the value of their holdings was recklessly put at risk by this manufactured crisis.

“At a time when the world economy requires strong US leadership, the world is getting just the opposite. That's not positive for America's future standing in the world,” the Curious Capitalist noted.

It will also further embolden many of the US’ critics. Yesterday, Russian Prime Minister Vladimir Putin accused the US of living beyond its means "like a parasite" on the global economy and said dollar dominance was a threat to the financial markets. "They are living beyond their means and shifting a part of the weight of their problems to the world economy," he said.

The next problem

Economically, America might have escaped a catastrophic debt default but the possibility of a downgrade still looms.

"While the above agreement represents progress, in our view it is certainly not a game changing breakthrough, and will keep the possibility of a near-term rating downgrade alive," wrote the Barclays Capital analysts. "It represents, in our view, just a band-aid approach on the way to more sustainable public finances."

The financial institution noted that a decision on a ratings downgrade may be pushed back to the final quarter of the year when it becomes clear whether unspecified cuts will really be implemented.

Last week, Moody's Investors Services said it would probably rate the US debt as AAA for now but with a negative outlook — a rating that indicates a possible downgrade yet to come.

Fitch Ratings, meanwhile indicated the deficit must be reduced to a "more sustainable level" for the US to maintain its AAA rating. And Standard & Poor's has said any deal to raise the debt ceiling must cut at least $4 trillion from future budget deficits or the rating will probably be lowered to AA.

Avalon Partners chief economist Peter Cardillo told AFP that he believes there is a 70 percent chance of the US being downgraded to an AA credit rating within the next six months, as more details of the spending cuts emerge.

A credit rating downgrade usually leads to higher interest rates, which makes it more expensive for governments, companies and consumers to borrow funds.

However, at this point, most analysts and bond traders believe that rates will not rise that much if the US loses its credit rating.

Nevertheless, confidence has been shaken in the US political process and politicians — and the economy, as a consequence.

As the Economist noted, “If Republicans are the clear winner from this deal, the economy is the loser. An ideal deficit-reduction package would have coupled near-term stimulus with long-term consolidation that stabilised then reduced the debt as a share of GDP. This deal certainly doesn’t do the first and it’s unclear that it will do the second.”

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